1.
Cost refers to
the total expenses incurred in the production of a commodity. Costs are studied
separately in the short run as well as in the long run.
2.
Types of short
run costs are: total cost, total variable cost, total fixed cost, SAC
(ATC),AFC,AVC and SMC
3.
The total cost of
a firm is the sum of total fixed cost and total variable cost, i.e.,
TC=TFC+TVC.
 |
| fig. graphical representation of relationship between total costs, variable costs, fixed costs |
4.
Fixed costs are
those that do not vary with the level of output. These are also called overhead costs. Examples of fixed costs
are: rent for factory building, minimum telephone bill, wages to permanent
staff, interest on capital etc. fixed
costs are formally called TFC (total fixed cost). Tc ate zero level of
output is TFC.
5.
Variable costs are those that change with the level of output. These are also called
prime cost. E xamples of variable costs are: labor costs and costs of raw
materials. Variable cost increases with output. Variable costs are formally called total variable cost (TVC). There
are no variable costs at zero output.
6.
Average cost
is obtained by dividing the total cost by the total number of units produced,
i.e., AC=TC/Q. Average cost is formally called ATC.
7.
There are two
types of average costs viz. average
fixed cost (AFC) and average variable cost (AVC).
8.
Average fixed cost (AFC) is obtained by dividing the total fixed cost by the total number of
units produced, i.e., AFC=TFC/Q. since the total fixed cost remains the same
with changes in output, therefore AFC falls steadily with the increase in
output. AFC curve is downward sloping.
9.
Average variable cost (AVC) is obtained by dividing the total variable cost
by the number of units produced, i.e, AVC=TVC/Q. AVC curve is of U-shape.
10.
There is a
relationship between ATC, AFC and AVC. ATc is the sum of AFC and AVC, i.e,
ATC=AFC+AVC.
11.
The behaviour of
ATC depends upon the behaiviour of AFC curve and AVC curve. Because both AFC
and AVC curve. Because both AFC and AVC fall in beginning, ATC will also fall
in the beginning. But after the firm has achieved optimum capacity, it will
begin to rise. Both AC or ATC and AVC are U-shaped.
12.
Marginal cost (MC) is an addition made to the total cost when output is changed by one unit,
i.e., MC=ΔTC/ ΔQ or MCn=TCn-TCn-1. Marginal cost
is also an addition made to total variable cost when output is changed by one
unit. Alternatively, marginal cost can also be expressed as MC= ΔTVC/ ΔQ. The sum
of MCs equals TVC, i.e., TVC=∑MC.
 |
| fig. Relationship between AC, AVC, MC |
13.
MC curve is a
mirror reflection of the MPP curve, i.e., MC=p/MMP where p stands for price per
unit and MMP stands for its marginal physical product . MPP generally rises, reaches
a maximum and then falls. Therefore, the marginal cost (MC) generally
decreases, reaches a maximum and then rises, i.e., MC curve is U-shaped. The reason
is the law of variable proportions.
14.
The average cost
(AC) curve is determined by the marginal cost curve because it is the marginal
cost which brings about a change in total cost and hence average cost. Thus TCn+1=TCn+MC
and ACn+1=TCn+1/Q. average cost has to decrease when MC
is decreasing.
15.
Once we know that
MC curve is U-shaped, it follows that the AVC and the ATC curves are U-shaped
also. Thus, the shape of the MC curve implies the similar shape of the AVC and
ATC curves. MC,AVC and ATC curves are generally U-shaped.
16.
There is close
relationship between AVC and MC curves
(i)
When AVC is
falling, MC lies below the AC curve, i.e., MC
(ii)
When AVC is
minimum and constant, AVC=MC. It implies that MC curve must cut the AVC curve
at the minimum point of AVC, and
(iii)
When AVC is
rising, MC lies above AVC curve, i.e., MC>AVC.
17.
The relationship
between AC (or ATC) and MC is the same as between AVC and MC.
18.
In the long run,
all inputs are variable and thus a distinction between fixed and variable cost
is not relevant for the long run. There are no TFC or AFC curves in the long
run. There is no distinction between TC and TVCs. There is also no distinction
between ATC and AVC and we simply use the term LAC where L stands for long run.
The concept of MC in the long run will be abbreviated as LMC.
19.
Like SAC and SMC
curves, the long run marginal cost (LMC) curve and long run average cost (LAC)
curves are also of U-shape but they are flatter. The U-shape of LAC curve
follows from a firm experiencing increasing returns to scale in itself,
followed by constant returns to scale and thereby decreasing returns to scale.
20.
The U-shape of
the LAC curve implies the U-shape of the LMc curves.
 |
| fig. relationship between LAC and LMC |
1.
The relationship
between LAC and LMC is the same as between SAC and SMC
(i)
When LMC is
falling, LMC lies below the LAC curve, i.e, LMC
(ii)
When LAC is
rising, LMC lies above the LAC curve, i.e, LMC>LAC and
(iii)
When LAC is
minimum and constant, LMC curve touches the LAC curve, i.e., LMC=LAC.
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